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We have done a pretty good job over the past year or so in offering up comparisons between upstream operating companies. We’ve hit the major shale players like Devon Energy, (NYSE:DVN), and Occidental Petroleum, (NYSE:OXY), as we as some of the big Canadian players like Canadian Natural Resources, (NYSE:CNQ), as well as the gas drillers. Nor have we missed the big International Oil Companies like, Chevron, (NYSE:CVX), and ExxonMobil, (NYSE:XOM).
When mulling over the topic for this month’s edition of Intelligent Investor, I thought it was time to move farther down the value chain and review a couple of refiners. This time around we are going to take a look at a couple of dedicated refining companies, both of which have roots that go deep into the past century.
Refining is a process that takes organic molecules coming from crude oil or other vegetable oil-based feedstock, and through thermal and pressure inputs, cracks them into useful products like gasoline, and diesel or jet fuel. Among the challenges U.S. refiners face are government-mandated formulas for their end products. These come in the form of requirements to blend various vegetable oils with petroleum to help meet air quality standards. In the past few years another mandate to reduce the carbon intensity of their operations and output. Toward that goal, many refiners are closing or repurposing oil refineries to accept alternative feedstocks.
In this article we will…
Introduction
We have done a pretty good job over the past year or so in offering up comparisons between upstream operating companies. We’ve hit the major shale players like Devon Energy, (NYSE:DVN), and Occidental Petroleum, (NYSE:OXY), as we as some of the big Canadian players like Canadian Natural Resources, (NYSE:CNQ), as well as the gas drillers. Nor have we missed the big International Oil Companies like, Chevron, (NYSE:CVX), and ExxonMobil, (NYSE:XOM).
When mulling over the topic for this month’s edition of Intelligent Investor, I thought it was time to move farther down the value chain and review a couple of refiners. This time around we are going to take a look at a couple of dedicated refining companies, both of which have roots that go deep into the past century.
Refining is a process that takes organic molecules coming from crude oil or other vegetable oil-based feedstock, and through thermal and pressure inputs, cracks them into useful products like gasoline, and diesel or jet fuel. Among the challenges U.S. refiners face are government-mandated formulas for their end products. These come in the form of requirements to blend various vegetable oils with petroleum to help meet air quality standards. In the past few years another mandate to reduce the carbon intensity of their operations and output. Toward that goal, many refiners are closing or repurposing oil refineries to accept alternative feedstocks.
In this article we will look at Phillips 66, (NYSE:PSX) and Marathon Petroleum Corp, (NYSE:MPC), to see which might offer the best value at this point in the oil market’s recovery.
The macro-environment for liquid fuels
There is a transition underway to change American driving habits from liquid fuels burned in internal combustion engines to electricity drawn from what are termed "renewable sources." These include rechargeable lithium-ion batteries, wind/solar installations, and liquid biofuels. The "wind is at the back" of this transition at the moment and it features prominently in national, state, and local government initiatives. Through tax incentives and credits, as well as disincentives for energy producers and refiners, changes are being made to the traditional energy mix. Ethanol and other biofuels are on the rise over the next couple of decades as shown in the EIA graphics below.
What is critical here is that by 2050 the use of petroleum sources and by extension-motor gasoline, registers only a modest decline from present levels. The primary reason for this is that in spite of governmental desires to use less petroleum, with the exception of hydrogen (the mass production of which is currently nascent) there is no other solution that provides as much energy per unit of mass. LNG, LPG, and biodiesel come close, but good old gasoline is still king.
I think a couple of conclusions can be drawn from this macro-picture. The first is that the thesis for continued production of petroleum-based fuels-gasoline and diesel is strong at least through 2050, and probably beyond. The second is that refiners need to adapt to the increased demand for biofuels by conversion of some of their existing petroleum refineries to cracking biofuel molecules.
Let’s do a quick rundown of some of the factors that influence refinery operations and therefore, profitability, before diving into the individual companies.
Factor# 1, Renewable Identification Numbers-RINs
RINs are part of a government-mandated Renewable Fuels Standard-RFS, whereby refiners obtain compliance by purchasing or manufacturing renewable fuels. There is also a market where RINs can be exchanged or sold, and prices fluctuate for a number of reasons.
Factor# 2, The Crack Spread
Often called the 321 Crack Spread, it refers to the input costs of 3 bbl crude versus the retailing margin on the typical 2 bbl of gasoline and 1 bbl of distillate that can be sold as diesel or jet fuel.
The tight spread gives refiners less margin to play with in generating proper returns. Some of this can be controlled with inputs, but one of the keys in refining is utilization, or through put. This was also noted in the call as regards imports of heavy crude vs exports to foreign markets-
Factor# 3, Western Canada Select- WCS blending differential
One man's strength is another's weakness. On calls with Canadian producers, the reduction of the spread between WCS and WTI bolsters earnings. If you're a Gulf Coast refiner buying WCS, this shows up as a weakness. Right now, refiners are buying a lot of heavy crude produced in Canada for blending with the light oil produced from shale wells.
In summary, in turning a profit in refining there are a lot of levers to pull. Any one or all of them can spring up and either make or kill a quarter.
Phillips 66
Phillips 66, bears a vestige of a historic name that harks back to the early days of petroleum exploration and production in the U.S. Frank Phillips was a hard-nosed Oklahoma banker when WW-I broke out. He saw an opportunity in oil and formed Phillips Petroleum Company. Over the next 100 years the company grew and in 2002, eventually merged with a legacy rival from the early days, Conoco Oil and Gas.
In 2012 the refining arm of the company was spun off to shareholders as Phillips 66, to unlock value. If you tracked this back to where the company began trading at $34 per share and added in all the dividends since you would have one of the best shareholder bonanzas in recent memory.
Phillips 66 has a broad footprint in the oil refining and petroleum based chemicals business, and is expanding into renewables by repurposing older facilities. The company is down 18% from mid-June highs, on some uncertainty about cost impacts in the refining business, after rallying 10% the past week. The questions before us then: Is this a good entry point for this solid 5%+ dividend payer, or is more pain ahead? And, is there a catalyst on the horizon to take it back toward recent highs?
Marketwatch
Let's check in with the analysts before going any further.
WSJ
These folks hold a fairly high opinion of the company. Price estimates range from a low of $73 to a high of $113. The low is just above the current price, so it’s not hard to see this one going higher.
In a late-breaking development, analyst firm, Cowan has cut their estimate for PSX to $73 from $80, due to a market misunderstanding about RIN exposure.
The thesis for PSX
Through its domestic and international network of refineries and chemical plants the company processes petroleum and extracts into finished and intermediate goods used for transport and in plastics manufacturing. The broad market outlook for these materials is limited somewhat at present by the new Covid outbreak, but on the whole is expected to increase to and exceed 2019 levels this year.
Viewing the graphic below, you can see the company has widely distributed assets in refining and midstream. Its concentration of the west coast is fortunate as that region has some of the most ambitious goals for the conversion of liquid fuels to renewable sources. It also has chemical and refining assets in Europe and the Middle East.
In spite of the conversion of much of industrial and residential energy to wind, solar, and hydroelectric power the EIA graphic below calls for a rebound in petroleum based liquid fuels next year.
So while the macro picture is on the rise, the case for PSX is complicated by a number of factors, anyone of which can take the wind out of an otherwise good market for their products. Particularly in refining.
Refining
RIN costs are likely a factor in the current discounting of PSX shares, where the company has lost $1.7 bn over the first half. I am not going to go into any more details about the RFS in this article. I would suggest that if you are considering taking a position in the company for growth or income, that you acquaint yourself with the factors influencing RINs. Management commented on RIN impact on the 2nd quarter-
“There is a lot of moving parts, in particular, the cost of RINs that just continue to increase throughout the quarter. And we take a pretty good hit in Refining for the full cost of those prints. I think we said on the last call, we really need to see that 3-2-1 frac on a RIN adjusted basis get back to about $12. And then I think we will see the appropriate kind of market captures around that to be able to generate something around $4 billion.”
Analysts on the call returned to this repeatedly in the call. I will say management's commentary was a bit jargon-y and full of euphemisms, making it hard to decode precisely at times. Shame on the analysts for not nailing them down.
The tightness of the crack spread gives refiners less margin to play with in generating proper returns, as we’ve noted. Some of this can be controlled with inputs, but one of the keys in refining is utilization, or through put. This was also noted in the PSX Q-2 call as regards imports of heavy crude vs exports to foreign markets-
“I think the second piece for us, in particular is more geared towards heavy crudes making diesel. And certainly, for the second quarter, it was a gasoline-driven market without much differential on heavy crude. And one of the reasons the Gulf Coast is weakening, is because low exports means that you have to have a weaker differential on WCS to get that WCS exported out of the U.S.”
This is a rip-roaring business driven by the need for plastic packaging in world markets today. Phillips and 50% owned JV partner ChevronPhillips Chemical, CPCChemical, have big plans for expansion in Old Ocean, Texas. At the Sweeny unit a world-scale ethylene cracker will be built to produce 1-hexane. This is a companion to another ethylene cracker already on-site.
“The new 1-hexene unit in Old Ocean will enjoy significant advantages in infrastructure, feedstock availability, and operational expertise. It will also benefit from the latest technology advances to achieve energy and emissions efficiency improvements. Once operational, it will further the company’s position as a leading 1-hexene supplier.”
PSX has a major refinery conversion and expansion underway to produce biodiesel in the San Francisco bay area at their old Rodeo refinery. Two hydrocrackers will be repurposed to crank out biodiesel, and another will be added. Similar projects are underway in other areas. With feedstock comprised of used vegetable oils and greases-(your biodiesel may smell like french fries), and being plant-based they are considered more environmentally friendly than petroleum fuels. This is largely because to get more biofuel, you have to grow another crop which sequesters Co2 in the plant mass...until it is burned. Hence its renewable-ness.
Here's a link to the Biofuel Tax Credit-BTC page describing the economic tax benefits of producing biofuel. Who wouldn't want to get on this gravy train? Particularly when the RFS which we've discussed in this piece, mandates biofuels inclusion? Greg Garland, CEO of PSX comments of the potential for the Rodeo refinery conversion-
“So what really sets up Rodeo completely differently, one is the full plant conversion, so we have all the kit available. And we have two very high-pressure hydrocrackers that we can put into service. And excess hydrogen capacity on site between our own hydrogen plant and that of our third-party supplier that is built at the site. So we have kind of got a perfect storm there. So we are spending money to get all the logistics right, a little bit of metaling up in the hydrocrackers and in the pretreatment unit, and we will be ready to go.”
In its Humber refinery, major changes are underway to produce biofuels as noted in the slide above. In FEED stages are plans to produce hydrogen at Humber through a CCUS project, and again in the Gigastack with partners Oersted- a wind farm operator to produce green hydrogen through electrolysis. The code name for all of these project is Humber Zero, and will be supported through U.K tax largesse similar to the States.
Retail
PSX has been rebranding and brightening up its retail outlets. Some six thousand are scheduled to get a facelift in a project that is about 80% complete. No commentary on whether they are putting in EV chargers in any of these outlets as part of this plan. Management comments on the retail upgrades-
“And we have been reimaging the stores for the past three years. We are up to 85% of the stores reimaged and we have seen the 2% to 3% jump in volumes and margins in those stores as well. So we have done a lot of things to help our portfolios in the right spots. And so I think that is where we saw the value in marketing in Q2.”
Phillips Partners-Midstream a possible Catalyst for PSX
74% owned Phillips Partners, (NYSE:PSXP) provides midstream and intermediate services. It was spun off in 2013 and like many such spin-offs has not lived up to initial expectations. An SPGlobal article notes that some of the initial economic justification has tempered. Some of the specific rationale may lie in the troubles Energy Transfer, (ET) is having with the Dakota Access Pipeline-DAPL, as the article notes. Roll-up of spun off pipeline entities is also in vogue presently.
Other refiners such as CVR Energy Inc., (NYSE:CVI) and Valero Energy Corp., (NYSE:VAL) have both rolled up their pipeline partnerships in recent years.
The potential roll-up and reincorporation of this network into PSX comes with pluses and minuses. On the plus side is the cash flow contributed from the assets. On the minus side would be the loss of the distributions paid to the general partner, from the partnership.
Q-2
Strong quarters from Chemicals and Marketing and Transportation, helped lessen the impact of the previously noted losses in refining, and notched earnings of $296 mm. Operating Cash Flow was strong, at $1.7 bn assisted by $910 mm in working capital, cash distributions from equity affiliates, and a tax refund. Capex was $380 mm and they paid a 5.6% yielding quarterly dividend of $396 mm.
The balance sheet is strong with $2.2 bn of cash on the books, and access to a total of $5.7 bn in credit facilities. With the PSXP debt consolidated to their balance sheet, PSX has $15 bn in long-term debt. Their consolidated net debt stands at 0.39%, anything less than 1:1 is considered investable usually.
Now, let’s take a look at our next refiner candidate for King of Oilfield Bargain Basement, Marathon Petroleum Corp.
Marathon Petroleum Corp
Marathon Petroleum Corp, (NYSE:MPC) is in much the same business as our prior candidate company. MPC refines crude oil into derivative fuels for the transportation and transports natural gas liquids-NGLs to plants producing various plastics. It operates under the same mandates as other refiners, and therefore must incorporate renewable fuels into its petroleum-based output. With the green energy initiatives now taking hold, MPC is in the process of repurposing some older refining assets to accept vegetable oil feedstocks. The stock sold down from the $60 level following the energy rout of early August but has rebounded toward that level as demand fears abated with the EIA reported crude and gasoline stock draws for the week ending August, 27th. It still remains significantly below its mid-June high.
Marketwatch
The thesis for MPC
MPC reported a rip-roaring quarter and as a result of the $21.0 bn sale of their Speedway stores, announced a $10 bn share buyback, of which they've already completed $1.0 bn. The rest of this share repurchase will occur over the next year and a half.
As noted, the shares are only off marginally this month from the $60 level. It's noteworthy that the 4.5% dividend yield is slightly less than that of PSX, perhaps implying a little more safety. We will look more closely at that as we select our winner for this month. Dividend yield is often thought of as a proxy for its relative safety. That is to say, the ability of the company to continue paying it.
The company is going heavy into petroleum refinery conversions to vegetable oils, sometimes called renewables. One is presently underway at their Martinez, California location, and the Dickinson, Nebraska refining conversion has just been completed. I view these as catalysts for growth, as long as too much debt isn't run up doing them.
MPC
As a final note here it is worth pointing out that the company has a monster amount of cash on their books-$13.2 bn. To what end, one can only speculate. Ostensibly, $9 bn of that is targeted toward share buybacks as noted. But, when companies have that kind of a cash stash it tends to burn a hole in management’s pockets at some point. The refining business is probably ripe for consolidation, efficiencies of scale are absolute in this business. Perhaps the acquisition of a technology provider that improves processes could be in their sights. Food for thought anyway as that much cash provides a lot of flexibility.
Q-2 for MPC
MPC reported a strong second quarter, beating analyst estimates on the top and bottom lines. Net income of $8.5 bn was the result of OCF of $985 mm and a gain on the sale of Speedway. The EBITDA generated in Q-2 was $8.8 bn on a one-year run-rate basis. With this cash infusion, retiring debt and returning capital to shareholders through stock buybacks are the company's two primary goals.
Long term debt was reduced by $2.5 bn to $27.5 bn. A step in the right direction with many more to come hopefully. The OCF of $985 mm covered the capex of $302 mm and the dividend of $386 mm, and providing a measure of safety that further borrowing won't be necessary to meet either.
Possible Catalysts
The key catalyst for MPC lies in the ramping up of its Renewable Fuels portfolio. As we have noted in the past, the RFS train is coming into the station. As a combination of control of the input value chain-which vegetable oils do you choose to turn into diesel, the renewable fuels energy credit, and the good wishes of governmental bodies wanting to stave off global warming, the biodiesel business case is too strong to ignore. As you can see, consumers are already conditioned to pay more for biodiesel, and that is an important point. I can remember driving across town to save 3 cents on a gallon of gasoline. When you shift the paradigm from one of saving every last nickel that you can while driving, to saving the planet by driving cleanly, you build in a lot of profit potential. The slide below shows biodiesel as the most expensive option.
One of the real estate maxims is that location is everything. This can also be applied as well to the Martinez refinery conversion. Mike Hennigan, CEO of MPC comments on the place utility of Martinez-
”But the thing that makes us feel really good about Martinez is several factors. One, we think we have a really competitive CapEx and OpEx situation, and that was one of the major drivers when we looked at this. Second, as Ray just mentioned, we have really, really strong logistics; pipeline, rail, water, truck, we have a lot of opportunity there to provide value.
And then the ultimate logistics is we're in California, where we're sitting on the demand. So location also matters. So regardless of what happens in the marketplace and it will ebb and flow just like every other commodity market? The reason we're so bullish on our Martinez asset is those factors that are in place day in and day out.”
MPC Q-2 call
Now a refinery is still a refinery no matter what the feedstock might be. But repurposing Martinez to biodiesel puts lipstick on the pig, so to speak. Marathon is positioning itself to be one of the biggest suppliers of this fuel on the national level. It sells for higher prices and helps meet MPC's Scope I, II emissions goals. It also promotes lower scope III emissions, and this is something courts and governments are starting to push for.
The possible roll-up of MPLX provides similar pluses and minuses to the situation faced by Phillips 66. On one side billions of assets and cash flow hit the books. On the other, the loss of juicy high-yielding distributions was thrown off by the partnership.
“I would tell you, right now, our thinking though is that we would stay in the MLP structure because we don't think it's going to change. We don't know for sure. Obviously, if it did lose its tax status, it would change our dynamic. But right now, Doug, if you're asking what's the probability, I think we are on the side of – we don't think it is going to change, and we think the partnership will still maintain its tax status.”
Finally, the share count reduction is certainly a potential catalyst. They have the cash on hand to get the total share count down to around 500 mm, a 25% improvement from present levels.
Risks
Refineries run, by and large on natural gas to fire the boilers and cat crackers. This was cited in the call as being a concern and potential headwind for the third quarter. MPC management noted the rising cost of fuel gas in their quarterly call with analysts.
“As you know, natural gas is a variable cost in operating a refinery, these costs have recently increased nearly $1 per MMBtu, and we anticipate this being a headwind for the third quarter.”
No commentary was noted about RIN costs, as was the case for PSX.
At risk for MPC shareholders would be the ~$1.0 bn in distributions paid to the company by MPLX. The benefit would be gaining the extensive assets owned by the Midstream entity, which includes pipelines as shown below and storage tanks and caverns to provide flexibility in production and transport.
PSX is a captive of higher oil prices and the factors as previously noted. Since product prices turned around last November, shares doubled before cooling off for reasons previously noted. Even with the sell-off PSX is still 40% above November levels.
PSX is also captive of refinery through put, currently up to 88% of capacity, and up from 74% in the prior quarter. If the Delta Covid variant now surging through the population takes a bite out of gasoline sales, the stock could be impacted when they report Q-3.
The real kicker is that PSX is currently trading at 20X adjusted EV/EBITDA. This is pretty high. 10X is often considered a threshold of investbility. I don't really see a near-term catalyst for the stock so, at current levels, I would have to rate it a hold. The income is very attractive, but it will likely remain stuck near current levels, as the company prioritizes debt reduction to shareholder returns.
That's my take on PSX at present. If we were to see some softness and decline toward the $50 level, I might reach out for that dividend. Long term I think the stock will be attractive, but the entry point is key. The refining space is clearing out, with a number of refinery outright closures, so the pie will get larger for those who remain. Patience is advised at current levels
This brings us to Marathon as the winner of this month’s comparison contest, the new King of the Oilfield Bargain Basement Bin. It really comes down to valuation. MPC has a strong business now and is adapting its model to shift production toward renewables. The debt is a bit staggering for a company the size of MPC and presents a risk should the market turn down. But then you have to remember the MPLX debt is consolidated to the MPC balance sheet as the slide below illustrates. Nor do they have any maturities that can't be rescheduled or retired through cash flow or capital raises in the near term.
That said the company has the potential to drastically reduce its share count as per the slide below. In a year and a half or so, they could be down around ~500,000,000 shares.
On an EV/EBITDA basis, the company is at 7X, a much better multiple than Phillips 66 at 20X. If you want to subtract their cash balance-which you really should do in this calculation, it falls toward 2-3X. In terms of dividend safety, catalysts for growth, and the potential for share count reduction, Marathon is a clear favorite for investors wishing to participate in the refining space.
As we have demonstrated in this article, liquid fuels have a long runway ahead of them for transportation uses. Companies like MPC will drive the transition to greener fuels and should have years of double-digit earnings with which to line investor’s pockets.
Oilprice.com's premium service for energy experts and investors, including a weekly newsletter that allows our members to stay ahead of markets and a monthly deep-dive…
